x QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30,
2018

OR

o TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from __________
to __________.

Commission file number 001-31972

TELKONET, INC.

(Exact name of Registrant as specified in
its charter)

Utah

87-0627421

(State or Other Jurisdiction of Incorporation or Organization)

(I.R.S. Employer Identification No.)

20800 Swenson Drive, Suite 175, Waukesha, WI

53186

(Address of Principal Executive Offices)

(Zip Code)

(414) 302-2299

(Registrant’s Telephone Number, Including
Area Code)

Indicate by check mark
whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding
12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark
whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required
to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months
(or for such shorter period that the registrant was required to submit and post such files). Yes x No
¨

Indicate by check mark
whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company,
or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller
reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer o

Non-accelerated filer o (Do not check if a smaller reporting company)

Smaller reporting company x

Emerging growth company o

If an emerging growth
company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any
new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate by check mark
whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. Yes o No
x

The number of shares
outstanding of the registrant’s common stock, par value $0.001 per share, as of July 31, 2018 is 133,989,919.

Series A, par value $.001 per share; 215 shares issued, 185 shares outstanding at June 30, 2018 and December 31, 2017, preference in liquidation of $1,562,848 and $1,526,141 as of June 30, 2018 and December 31, 2017, respectively

1,340,566

1,340,566

Series B, par value $.001 per share; 538 shares issued, 52 shares outstanding at June 30, 2018 and December 31, 2017, preference in liquidation of $424,583 and $414,258 as of June 30, 2018 and December 31, 2017, respectively

362,059

362,059

Common stock, par value $.001 per share; 190,000,000 shares authorized; 133,989,919 and 133,695,111 shares issued and outstanding at June 30, 2018 and December 31, 2017, respectively

133,989

133,695

Additional paid-in-capital

127,460,169

127,421,402

Accumulated deficit

(121,545,404

)

(119,724,656

)

Total stockholders’ equity

7,751,379

9,533,066

Total Liabilities and Stockholders’ Equity

$

10,555,220

$

12,547,583

See accompanying notes to the unaudited
condensed consolidated financial statements

3

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS

(UNAUDITED)

Three Months Ended

June 30,

Six Months Ended

June 30,

2018

2017

2018

2017

Revenues, net:

Product

$

2,820,805

$

2,013,922

$

4,324,463

$

3,824,307

Recurring

153,357

110,201

254,895

213,043

Total Net Revenue

2,974,162

2,124,123

4,579,358

4,037,350

Cost of Sales:

Product

1,376,729

1,065,914

2,370,966

2,073,959

Recurring

66,482

32,627

126,479

62,645

Total Cost of Sales

1,443,211

1,098,541

2,497,445

2,136,604

Gross Profit

1,530,951

1,025,582

2,081,913

1,900,746

Operating Expenses:

Research and development

431,856

444,557

870,636

823,013

Selling, general and administrative

1,291,103

1,438,069

2,568,006

3,207,762

Depreciation and amortization

16,628

9,880

33,543

19,789

Total Operating Expenses

1,739,587

1,892,506

3,472,185

4,050,564

Operating Loss

(208,636

)

(866,924

)

(1,390,272

)

(2,149,818

)

Other Income (Expenses):

Interest income (expense), net

4,054

4,428

1,524

(5,925

)

Total Other Income (Expense)

4,054

4,428

1,524

(5,925

)

Loss from Continuing Operations before Provision for Income Taxes

(204,582

)

(862,496

)

(1,388,748

)

(2,155,743

)

Provision for Income Taxes

2,000

6,910

2,000

7,901

Net loss from continuing operations

(206,582

)

(869,406

)

(1,390,748

)

(2,163,644

)

Discontinued Operations:

Gain from sale of discontinued operations (net of tax)

–

–

–

6,384,871

Income from discontinued operations (net of tax)

–

18,855

–

590,657

Net income (loss) attributable to common stockholders

$

(206,582

)

$

(850,551

)

$

(1,390,748

)

$

4,811,884

Net income (loss) per common share:

Basic - continuing operations

$

(0.00

)

$

(0.01

)

$

(0.01

)

$

(0.02

)

Basic - discontinued operations

$

–

$

0.00

$

–

$

0.05

Basic – net income (loss) attributable to common stockholders

$

(0.00

)

$

(0.01

)

$

(0.01

)

$

0.04

Diluted - continuing operations

$

(0.00

)

$

(0.01

)

$

(0.01

)

$

(0.02

)

Diluted - discontinued operations

$

–

$

0.00

$

–

$

0.05

Diluted – net income (loss) attributable to common stockholders

$

(0.00

)

$

(0.01

)

$

(0.01

)

$

0.04

Weighted Average Common Shares Outstanding – basic

133,989,919

133,015,191

133,843,329

132,894,833

Weighted Average Common Shares Outstanding –diluted

133,739,919

133,015,191

133,961,689

133,490,201

See accompanying notes to the unaudited
condensed consolidated financial statements

4

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(UNAUDITED)

SIX MONTHS FROM JANUARY 1, 2018 THROUGH
JUNE 30, 2018

Series A Preferred Stock

Series A Preferred Stock

Series B Preferred Stock

Series B Preferred Stock

Common

Common Stock

Additional Paid-in

Accumulated

Total Stockholders’

Shares

Amount

Shares

Amount

Shares

Amount

Capital

Deficit

Equity

Balance at December 31, 2017

185

$

1,340,566

52

$

362,059

133,695,111

$

133,695

$

127,421,402

$

(119,724,656

)

$

9,533,066

January 1, 2018, Cumulative
effect of a change in accounting principle related to ASC 606, net of tax

–

–

–

–

–

–

–

(430,000

)

(430,000

)

Shares issued to directors

–

–

–

–

294,808

294

35,706

–

36,000

Stock-based compensation expense
related to employee stock options

–

–

–

–

–

–

3,061

–

3,061

Net loss

–

–

–

–

–

–

–

(1,390,748

)

(1,390,748

)

Balance at June 30, 2018

185

$

1,340,566

52

$

362,059

133,989,919

$

133,989

$

127,460,169

$

(121,545,404

)

$

7,751,379

See accompanying notes to the unaudited
condensed consolidated financial statements

5

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS

(UNAUDITED)

For the Six Months Ended

June 30,

2018

2017

Cash Flows from Operating Activities:

Net income (loss)

$

(1,390,748

)

$

4,811,884

Less: Net income from discontinued operations

–

(590,657

)

Gain on sale of discontinued operations

–

(6,384,871

)

Net loss from continuing operations

(1,390,748

)

(2,163,644

)

Adjustments to reconcile net (loss) from continuing operations to cash used in operating activities of continuing operations:

Stock-based compensation expense

3,061

318,202

Shares issued to directors as compensation

36,000

72,000

Depreciation

33,543

19,789

Provision for doubtful accounts, net of recoveries

(75

)

72,396

Changes in operating assets and liabilities:

Accounts receivable

(373,066

)

(140,141

)

Inventories

276,968

74,559

Prepaid expenses and other current assets

(452,538

)

(182,864

)

Deposits and other long term assets

–

(17,130

)

Accounts payable

(17,997

)

(97,175

)

Accrued liabilities and expenses

65,966

(76,498

)

Contract liability

268,010

–

Deferred revenue

(512,066

)

144,608

Related party payable

–

(97,127

)

Customer deposits

(124,380

)

159,975

Contract assets

(4,684

)

–

Income tax payable

–

139,884

Deferred lease liability

13,002

3,098

Net Cash Used In Operating Activities of Continuing Operations

(2,179,004

)

(1,770,068

)

Net Cash Provided By Operating Activities of Discontinued Operations

–

517,242

Net Cash Used In Operating Activities

(2,179,004

)

(1,252,826

)

Cash Flows From Investing Activities:

Purchase of property and equipment

(7,493

)

(12,011

)

Net proceeds from sale of subsidiary

–

11,805,220

Net Cash Used
In Investing Activities of Continuing Operations

(7,493

)

11,793,209

Cash Flows From Financing Activities:

Net payments on line of credit

(682,211

)

(1,062,129

)

Net Cash Used In Financing Activities of Continuing Operations

(682,211

)

(1,062,129

)

Net increase (decrease) in cash and cash equivalents

(2,868,708

)

9,478,254

Cash and cash equivalents at the beginning of the period

9,195,595

791,858

Cash, cash equivalents and restricted cash at the end
of the period

$

6,326,887

$

10,270,112

See accompanying notes to the unaudited
condensed consolidated financial statements

6

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS (Continued)

(UNAUDITED)

Six Months Ended

June 30,

2018

2017

Supplemental Disclosures of Cash Flow Information:

Cash transactions:

Cash paid during the period for interest

$

5,326

$

11,173

Cash paid during the period for income taxes, net of refunds

–

8,151

See accompanying notes to the unaudited
condensed consolidated financial statements

7

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

JUNE 30, 2018

(UNAUDITED)

NOTE A – BASIS OF PRESENTATION
AND SIGNIFICANT ACCOUNTING POLICIES

A summary of the significant accounting
policies applied in the preparation of the accompanying condensed consolidated financial statements follows.

General

The accompanying unaudited condensed consolidated
financial statements of Telkonet, Inc. (the “Company”, “Telkonet”) have been prepared in accordance with
Rule S-X of the Securities and Exchange Commission (the “SEC”) and with the instructions to Form 10-Q. Accordingly,
they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial
statements.

In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair presentation have been included. However, the results
from operations for the six months ended June 30, 2018, are not necessarily indicative of the results that may be expected for
the year ending December 31, 2018. The unaudited condensed consolidated financial statements should be read in conjunction with
the consolidated December 31, 2017 financial statements and footnotes thereto included in the Company's Form 10-K filed with the
SEC. Refer to Note C – Revenue for the adoption of a new revenue recognition standard in the first quarter of 2018.

Business and Basis of Presentation

Telkonet, formed in 1999 and incorporated
under the laws of the state of Utah, is the creator of the EcoSmart Platform of intelligent automation solutions designed to optimize
energy efficiency, comfort and analytics in support of the emerging Internet of Things (“IoT”).

In 2007, the Company acquired substantially
all of the assets of Smart Systems International (“SSI”), which was a provider of energy management products and solutions
to customers in the United States and Canada and the precursor to the Company’s EcoSmart platform. The EcoSmart platform
provides comprehensive savings, management reporting, analytics and virtual engineering of a customer’s portfolio and/or
property’s room-by-room energy consumption. Telkonet has deployed more than a half million intelligent devices worldwide
in properties within the hospitality, military, educational, healthcare and other commercial markets. The EcoSmart platform is
rapidly being recognized as a leading solution for reducing energy consumption, operational costs and carbon footprints, and eliminating
the need for new energy generation in these marketplaces – all while improving occupant comfort and convenience.

On March 28, 2017, the Company sold substantially
all of the assets of its wholly-owned subsidiary, EthoStream LLC. Refer to Note M for further details.

The condensed consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiary, Telkonet Communications, Inc. The prior year accounts of EthoStream
LLC have been classified as discontinued operations on the consolidated statement of operations and the consolidated statement
of cash flows. All significant intercompany balances and transactions have been eliminated in consolidation.

We have financed our operations since inception
primarily through private and public offerings of our equity securities, the issuance of various debt instruments and asset based
lending.

The Company reported a net loss from continuing
operations of $1,390,748 for the six months ended June 30, 2018, had cash used in operating activities from continuing operations
of $2,179,004, had an accumulated deficit of $121,545,405 and total current assets in excess of current liabilities of $7,723,791
as of June 30, 2018.

8

Income (Loss) per Common Share

The Company computes earnings per share
under Accounting Standards Codification (“ASC”) 260-10, “Earnings Per Share”. Basic net income (loss) per
common share is computed using the treasury stock method, which assumes that the proceeds to be received on exercise of outstanding
stock options and warrants are used to repurchase shares of the Company at the average market price of the common shares for the
year. Dilutive common stock equivalents consist of shares issuable upon the exercise of the Company's outstanding stock options
and warrants. For the six months ended June 30, 2018 and 2017, there were 3,557,399 and 5,701,800 shares of common stock underlying
options and warrants excluded due to these instruments being anti-dilutive, respectively.

Use of Estimates

The preparation of financial statements
in conformity with United States of America (U.S.) generally accepted accounting principles (GAAP) requires management to make
certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting
period. Estimates are used when accounting for items and matters such as revenue recognition and allowances for uncollectible accounts
receivable, inventory obsolescence, depreciation and amortization, long-lived assets, taxes and related valuation allowance, income
tax provisions, stock-based compensation, and contingencies. The Company believes that the estimates, judgments and assumptions
are reasonable, based on information available at the time they are made. Actual results may differ from those estimates.

Income Taxes

The Company accounts for income taxes in
accordance with ASC 740-10 “Income Taxes.” Under this method, deferred income taxes (when required) are provided based
on the difference between the financial reporting and income tax bases of assets and liabilities and net operating losses at the
statutory rates enacted for future periods. The Company has a policy of establishing a valuation allowance when it is more likely
than not that the Company will not realize the benefits of its deferred income tax assets in the future.

The Company adopted ASC 740-10-25, which
prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position
taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on derecognition, classification, treatment
of interest and penalties, and disclosure of such positions.

The U.S. Tax Cuts and Jobs Act (“Tax
Act”) was enacted on December 22, 2017. The Tax Act makes broad complex changes to the U.S. tax code including, but not limited
to, reducing the U.S. federal corporate tax rate from 35% to 21%, requiring companies to pay a one-time transition tax on earnings
of certain foreign subsidiaries that were previously tax deferred, and creating new taxes on certain foreign sourced earnings and
additional limitations on the deductibility of interest.

The SEC issued Staff Accounting Bulletin
No. 118 (SAB 118) in December, 2017, to provide guidance on accounting for the effects of the Tax Act. SAB 118 provides for a measurement
period of up to one year from the Tax Act enactment date for companies to complete their assessment of and accounting for those
effects of the Tax Act. Under SAB 118, a company must first reflect the income tax effects of the Tax Act for which the accounting
is complete in the period of the date of enactment. To the extent the accounting for other income tax effects is incomplete, but
a reasonable estimate can be determined, companies must record a provisional estimate to be included in their financial statements.
For any income tax effect for which a reasonable estimate cannot be determined, an entity must continue to apply ASC 740 based
on the provisions of the tax laws in effect immediately prior to the Tax Act being enacted until such time as a reasonable estimate
can be determined. The Company requires additional time to complete its analysis of the impacts of the Tax Act and therefore its
accounting for the Tax Act is provisional but is a reasonable estimate based on available information. The Company will complete
its analysis and finalize its accounting for this provisional estimate during the one year measurement period as prescribed by
SAB 118.

Revenue from Contracts with Customers

Accounting Standards Codification Topic
606, Revenue from Contracts with Customers (“ASC 606, the Standard”) supersedes nearly all legacy revenue recognition
guidance. ASC 606 outlines a comprehensive five-step revenue recognition model based on the principle that an entity should recognize
revenue based on when it satisfies its performance obligations by transferring control of promised goods or services in an amount
that reflects the consideration to which the entity expects to be entitled in exchange for said goods or services.

9

Identify the customer contracts

The Company accounts for a customer contract
under ASC 606 when the contract is legally enforceable. A contract is legally enforceable when all of the following criteria are
met: (1) the contract has been approved by the Company and the customer and both parties are committed to perform their respective
obligations, (2) the Company can identify each party’s rights regarding goods or services transferred, (3) the Company can
identify payment terms for goods or services transferred, (4) the contract has commercial substance, and (5) collectability of
all the consideration to which the Company is entitled in exchange for the goods or services transferred is probable.

A contract does not exist if each party
to the contract has the unilateral right to terminate a wholly unperformed contract without compensating the other party (or parties).
Nearly all of the Company’s contracts do not contain such mutual termination rights for convenience. All contracts are in
written form.

Identify the performance obligations

The Company will enter into product only
contracts that contain a single performance obligation related to the transfer of EcoSmart products to a customer.

The Company will also enter into certain
customer contracts that encompass product and installation services, referred to as “turnkey” solutions. These contracts
ultimately provide the customer with a solution that enhances the functionality of the customer’s existing equipment. For
this reason, the Company has determined that the product and installation services are not separately identifiable performance
obligations, but in essence represent one, combined performance obligation (“turnkey”).

The Company also offers post-installation
support services to customers. Support services are considered a separate performance obligation.

Determine the transaction price

The Company generally enters into contracts
containing fixed prices. It is not customary for the Company to include contract terms that would result in variable consideration.
In the rare situation that a contract does include this type of provision, it is not expected to result in a material adjustment
to the transaction price. The Company regularly extends pricing discounts; however, they are negotiated up front and adjust the
fixed transaction price set out in the contract.

Customer contracts will typically contain
upfront deposits that will be applied against future invoices, as well as customer retainage. The intent of any required deposit
or retainage is to ensure that the obligations of either party are honored and follow customary industry practices. In addition,
the Company will typically be paid in advance at the beginning of any support contracts, consistent with industry practices. None
of these payment provisions are intended to represent significant implicit financing. The Company’s standard payment terms
are thirty days from invoice date. Products are fully refundable when returned in their original packaging without damage or defacing
less a restocking fee not to exceed fifty (50%) percent of the product’s price. Historical returns have shown to be immaterial.
The Company offers a standard one-year assurance warranty. However customers can purchase an extended warranty. Under the new standard,
extended warranties are accounted for as a service warranty, requiring the revenue to be recognized over the extended service periods.
Contracts involving an extended warranty are immaterial and will continue to be combined with support revenue and recognized on
a straight-line basis over the support revenue term.

Allocate the transaction price to the performance obligations

Revenues from customer contracts are allocated
to the separate performance obligations based on their relative stand-alone selling price (“SSP”) at contract inception.
The SSP is the price at which the Company would sell a promised good or service separately. The best evidence of an SSP is the
observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar
customers. However, turnkey solutions are sold for a broad range of amounts resulting from, but not limited to, tiered discounting
for value added resellers (“VAR”) based upon committed volumes and other economic factors. Due to the high variability
of our pricing, the Company cannot establish a reliable SSP using observable data. Accordingly, the Company uses the residual approach
to allocate the transaction price to performance obligations related to its turnkey solutions.

All support service agreements, whether
single or multi-year terms, automatically renew for one-year terms at a suggested retail price (“SRP”). Support service
renewals are consistently priced and therefore would support the use of SRP as the best estimate of an SSP for such performance
obligations.

10

Recognize Revenue

The Company recognizes revenues from product
only sales at a point in time, when control over the product has transferred to the customer. As the Company’s principal
terms of sale are FOB shipping point, the Company primarily transfers control and records revenue for product only sales upon shipment.

A typical turnkey project involves the
installation and integration of 200-300 rooms in a customer-controlled facility and usually takes sixty days to complete. Since
control over goods and services transfers to a customer once a room is installed, the Company recognizes revenue for turnkey solutions
over time. The Company uses an outputs measure based on the number of rooms installed to recognize revenues from turnkey solutions.

Revenues from support services are recognized
over time, in even daily increments over the term of the contract.

Deferred revenue includes deferrals for
the monthly support service fees. Long-term deferred revenue represents support service fees that will be recognized as revenue
after June 30, 2019.

Transition

The Company adopted ASC 606 using a modified
retrospective approach to all contracts not completed as of January 1, 2018. Results for reporting periods beginning January 1,
2018 are presented under ASC 606, while prior period amounts were not adjusted and continue to be reported in accordance with the
Company’s historic accounting under Topic 605, Revenue Recognition. The Company recorded a net decrease to beginning retained
earnings of $0.43 million as of January 1, 2018 due to the cumulative impact of adopting ASC 606. The impact to beginning retained
earnings was primarily driven by the deferral of revenue for unfulfilled performance obligations related to the Company’s
turnkey solutions.

Guarantees and Product Warranties

The Company records a liability for potential
warranty claims in cost of sales at the time of sale. The amount of the liability is based on the trend in the historical ratio
of claims to sales, the historical length of time between the sale and resulting warranty claim, new product introductions and
other factors. The products sold are generally covered by a warranty for a period of one year. In the event the Company determines
that its current or future product repair and replacement costs exceed its estimates, an adjustment to these reserves would be
charged to earnings in the period such determination is made. For the six months ended June 30, 2018 and the year ended December
31, 2017, the Company experienced returns of approximately 1% to 2% of materials included in the cost of sales. As of June 30,
2018 and December 31, 2017, the Company recorded warranty liabilities in the amount of $60,622 and $59,892, respectively, using
this experience factor range.

Product warranties for the six months ended
June 30, 2018 and the year ended December 31, 2017 are as follows:

June 30, 2018

December 31, 2017

Beginning balance

$

59,892

$

95,540

Warranty claims incurred

(7,117

)

(84,087

)

Provision charged to expense

7,847

48,439

Ending balance

$

60,622

$

59,892

NOTE B – NEW ACCOUNTING PRONOUNCEMENTS

In February 2016, the FASB issued ASU No.
2016-02, Leases (“ASU 2016-02”). The new standard establishes a right-of-use (ROU) model that requires a lessee to
record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified
as either finance or operating, with classification affecting the pattern of expense recognition in the statement of operations.
ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.
A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into
after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients
available. The Company is currently evaluating the impact of its pending adoption of ASU 2016-02 on its consolidated financial
statements. Upon adoption, the Company expects that the ROU asset and lease liability will be recognized in the balance sheets
in amounts that will be material.

11

In June 2016, the FASB issued ASU No. 2016-13,
Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-13 provides
guidance for estimating credit losses on certain types of financial instruments, including trade receivables, by introducing an
approach based on expected losses. The expected loss approach will require entities to incorporate considerations of historical
information, current information and reasonable and supportable forecasts. ASU 2016-13 also amends the accounting for credit losses
on available-for-sale debt securities and purchased financial assets with credit deterioration. The guidance is effective for fiscal
years beginning after December 15, 2019, including interim periods within those fiscal years. The guidance requires a modified
retrospective transition method and early adoption is permitted. The Company does not expect the adoption of ASU 2016-13 to have
a material impact on its consolidated financial statements.

Management has evaluated other recently
issued accounting pronouncements and does not believe that any of these pronouncements will have a significant impact on our consolidated
financial statements and related disclosures.

Accounting Standards Recently Adopted

Effective January 1, 2018, the Company
has adopted Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (“ASC 606, the Standard”),
which supersedes nearly all legacy revenue recognition guidance. ASC 606 outlines a comprehensive five-step revenue recognition
model based on the principle that an entity should recognize revenue based on when an it satisfies its performance obligations
by transferring control of promised goods or services in an amount that reflects the consideration to which the entity expects
to be entitled in exchange for said goods or services.

Effective January 1, 2018, the Company
has adopted ASU No. 2016-18, Statement of Cash Flows: Restricted Cash, (“Update 2016-18”). Update 2016-18
provides guidance on the classification of restricted cash in the statement of cash flows. The amendments are effective for interim
and annual periods beginning after December 15, 2017. The amendments in Update 2016-18 was adopted on a retrospective basis. Due
to the adoption of ASU 2016-18, the cash, cash equivalents and restricted cash presented in the Condensed Consolidated Statement
of Cash Flows for the six months ended June 30, 2018 and 2017 increased by $10,000 and $900,000 of restricted cash held as of June
30, 2018 and 2017, respectively.

NOTE C– REVENUE

The following table presents the Company’s
product and recurring revenues disaggregated by industry for the three months ended June 30, 2018.

Hospitality

Education

Multiple Dwelling Units

Government

Total

Recurring

$

133,468

$

11,055

$

8,834

$

–

$

153,357

Product

2,061,985

645,658

47,636

65,526

2,820,805

$

2,195,453

$

656,713

$

56,470

$

65,526

$

2,974,162

The following table presents the Company’s
product and recurring revenues disaggregated by industry for the six months ended June 30, 2018.

Hospitality

Education

Multiple Dwelling Units

Government

Total

Recurring

$

224,730

$

21,310

$

8,855

$

–

$

254,895

Product

3,543,140

639,928

67,962

73,433

4,324,463

$

3,767,870

$

661,238

$

76,817

$

73,433

$

4,579,358

Sales taxes and other usage-based taxes
are excluded from revenues.

Contract assets

Contracts are billed in accordance with
the terms and conditions, either at periodic intervals or upon substantial completion. This can result in billing occurring subsequent
to revenue recognition, resulting in contract assets. Contract assets are presented as current assets in the Condensed Consolidated
Balance Sheet. The balance of contract assets as of June 30, 2018 and at the date of adoption of ASC 606 was $0.35 million and
$0.35 million, respectively. There were approximately $0.1 million of costs incurred to fulfill a contract in the closing balance
of contract assets.

Contract liabilities

Contracts are billed in accordance with
the terms and conditions, either at periodic intervals or upon substantial completion. Often, the Company will require customers
to pay a deposit upon contract signing that will be applied against work performed or products shipped. In addition, the Company
will often invoice the full term of support at the start of the support period. Billings that occur prior to revenue recognition
result in contract liabilities. As of June 30, 2018 and at the date of adoption of ASC 606, contract liabilities were $1.05 million
and $0.78 million, respectively. The change in the contract liability balance during the six-month period ended June 30, 2018 is
the result of cash payments received and billing in advance of satisfying performance obligations, less $0.79 million of revenue
recognized during the period that was included in the contract liability balance at the date of adoption.

12

Contract costs

Costs to fulfill a turnkey contract primarily
relate to the materials cost and direct labor and are recognized proportionately as the performance obligation is satisfied. The
Company will defer cost to fulfill a contract when materials have shipped (and control over the materials has transferred to the
customer), but an insignificant amount of rooms have been installed. The Company will recognize any deferred costs in proportion
to revenues recognized from the related turnkey contract. The Company does not expect deferred contract costs to be long-lived
since a typical turnkey project takes sixty days to complete. Deferred contract costs are generally presented as other current
assets in the condensed consolidated balance sheets.

The Company incurs incremental costs to
obtain a contract in the form of sales commissions. These costs, whether related to performance obligations that extend beyond
twelve months or not, are immaterial and will continue to be recognized in the period incurred within selling, general and administrative
expenses.

The tables below present the impacts of
our adoption of the new revenue standard on our income statement and balance sheet.

For the Three Months Ended

June 30, 2018

As Reported

Balance Without Adoption of

ASC 606

Effect of

Change Higher/(Lower)

Income Statement:

Sales

$

2,974,162

$

3,054,562

$

(80,400

)

Cost of Goods Sold

1,443,211

1,466,011

(22,800

)

Net loss

$

206,582

$

148,982

$

57,600

For the Six Months Ended

June 30, 2018

As Reported

Balance Without Adoption of

ASC 606

Effect of

Change Higher/(Lower)

Income Statement:

Sales

$

4,579,358

$

4,762,758

$

(183,400

)

Cost of Goods Sold

2,497,446

2,554,746

(57,300

)

Net loss

$

1,390,748

$

1,264,648

$

126,100

As of June 30, 2018

As Reported

Balance Without Adoption of

ASC 606

Effect of

Change Higher/(Lower)

Balance Sheet:

Assets

Contract Assets

$

353,684

–

$

353,684

Inventories

982,568

1,164,932

(182,364

)

Liabilities

Contract Liabilities

1,047,010

–

1,047,010

Customer Deposits

–

66,226

(66,226

)

Deferred Revenue - Current

–

47,439

(47,439

)

Deferred Revenue – Long Term

–

205,925

(205.925

)

Equity

Accumulated Deficit

–

556,100

$

(556,100

)

13

The table below presents the cumulative
effect of the changes made to our consolidated balance sheet as of January 1, 2018 after the adoption of ASU 2014-09.

December 31, 2017

Transition Adjustments

January 1,

2018

Balance Sheet:

Assets

Contract Assets

–

110,000

$

110,000

Inventories

777,202

239,000

1,016,202

Liabilities

Contract Liabilities

–

779,000

779,000

Equity

Accumulated Deficit

$

(119,724,656

)

(430,000

)

$

(120,154,656

)

Remaining performance obligations

As of June 30, 2018, the aggregate amount
of the transaction price allocated to remaining performance obligations was approximately $0.35 million. Except for support services,
the Company expects to recognize 100% of the remaining performance obligations over the next six months.

NOTE D – ACCOUNTS RECEIVABLE

Components of accounts receivable as of June 30, 2018 and December
31, 2017 are as follows:

June 30, 2018

December 31, 2017

Accounts receivable

$

1,996,969

$

1,632,459

Allowance for doubtful accounts

(13,542

)

(22,173

)

Accounts receivable, net

$

1,983,427

$

1,610,286

NOTE E – ACCRUED LIABILITIES AND EXPENSES

Accrued liabilities and expenses at June 30, 2018 and December
31, 2017 are as follows:

June 30, 2018

December 31, 2017

Accrued liabilities and expenses

$

387,920

$

294,709

Accrued payroll and payroll taxes

243,908

230,931

Accrued sales taxes, penalties, and interest

42,330

83,282

Product warranties

60,622

59,892

Total accrued liabilities and expenses

$

734,780

$

668,814

NOTE F – DEBT

Revolving Credit Facility

The Heritage Bank Loan Agreement (the “Credit
Facility”) contains representations and warranties, covenants, and other provisions customary to transactions of this nature.
As of June 30, 2018, the Company was in compliance with all financial covenants. The outstanding principal balance of the Credit
Facility bears interest at the Prime Rate plus 3.00%, which was 8% at June 30, 2018 and 7.50% at December 31, 2017. The outstanding
balance on the Credit Facility was zero and $682,211 at June 30, 2018 and December 31, 2017, respectively. The remaining available
borrowing capacity was approximately $1,622,000 and $202,000 at June 30, 2018 and December 31, 2017, respectively.

On March 31, 2018, an amendment to the
revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the
terms of the amendment was that if the Company fails to comply with required EBITDA covenants as of any particular quarterly measurement
date, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted cash maintained
at Heritage Bank is in excess of $5,000,000.

14

NOTE G – PREFERRED STOCK

Preferred stock carries certain preference
rights as detailed in the Company’s Amended Articles of Incorporation related to both the payment of dividends and as to
payments upon liquidation in preference to any other class or series of capital stock of the Company. As of June 30, 2018, the
liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of $424,583,
which includes cumulative accrued unpaid dividends of $164,583, and second, Series A with a preference value of $1,562,848, which
includes cumulative accrued unpaid dividends of $637,848. As of December 31, 2017, the liquidation preference of the preferred
stock is based on the following order: first, Series B with a preference value of $414,258, which includes cumulative accrued unpaid
dividends of $154,258, and second, Series A with a preference value of $1,526,141, which includes cumulative accrued unpaid dividends
of $601,141.

NOTE H – CAPITAL STOCK

The Company has authorized 190,000,000
shares of common stock with a par value of $.001 per share. As of June 30, 2018 and December 31, 2017 the Company had 133,989,919
and 133,695,111 common shares issued and outstanding.

NOTE I – STOCK OPTIONS
AND WARRANTS

Employee Stock Options

The Company maintains an equity incentive
plan, (the “Plan”). The Plan was established in 2010 as an incentive plan for officers, employees, non-employee directors,
prospective employees and other key persons. It is anticipated that providing such persons with a direct stake in the Company’s
welfare will assure a better alignment of their interests with those of the Company and its stockholders.

The following table summarizes the changes
in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company
under the Plan as of June 30, 2018.

There were zero and 3,000,000 options granted,
1,069,075 and zero options cancelled or expired and zero options exercised during the six months ended June 30, 2018 and 2017,
respectively. Total stock-based compensation expense in connection with options granted to employees recognized in the condensed
consolidated statements of operations for the three and six months ended June 30, 2018 and 2017 was $1,531 and $3,516, respectively,
and $3,061, and $318,202, respectively.

15

Warrants

The following table summarizes the changes
in warrants outstanding and the related prices for the shares of the Company’s common stock issued to non-employees of the
Company.

Warrants Outstanding

Warrants Exercisable

Exercise Prices

Number Outstanding

Weighted Average Remaining Contractual Life (Years)

Weighted Average Exercise Price

Number Exercisable

Weighted Average Exercise Price

$

0.20

250,000

3.27

$

0.20

250,000

$

0.20

Transactions involving warrants are summarized as follows:

Number of Shares

Weighted Average Price Per Share

Outstanding at January 1, 2017

300,000

$

0.20

Issued

–

–

Exercised

–

–

Cancelled or expired

(50,000

)

0.18

Outstanding at December 31, 2017

250,000

0.20

Issued

–

–

Exercised

–

–

Cancelled or expired

–

–

Outstanding at June 30, 2018

250,000

$

0.20

There were no warrants granted, exercised,
cancelled or forfeited during the six months ended June 30, 2018 and 2017.

NOTE J – RELATED PARTY
TRANSACTIONS

During the six months ended June
30, 2018 and during the year ended December 31, 2017, the Company agreed to issue common stock in the amount of $36,000 and $144,000,
respectively, to the Company’s non-employee directors as compensation for their attendance and participation in the Company’s
Board of Director and committee meetings.

Upon execution of their employment agreements
during the six months ended June 30, 2017, the CEO, CTO and former COO, were each granted 1,000,000 stock options at their fair
market value and were scheduled to vest over a three year period. However, pursuant to their employment agreements, the stock options
vested immediately upon the sale of the Company’s subsidiary, EthoStream, in March 2017. Effective with the sale of
the assets of EthoStream, the former COO was hired by DCI. In compliance with the terms of the former COO’s stock option
grant letter, the former COO’s stock options were canceled during the six months ended June 30, 2018.

During the six months ended June 30, 2017,
the CEO, CTO, and former COO, each earned a bonus of $29,250 that was contingent on the sale and sale price amount of EthoStream.

NOTE K – COMMITMENTS AND CONTINGENCIES

Office Lease Obligations

Commitments for minimum rentals under non-cancelable
leases as of June 30, 2018 are as follows:

2018 (remainder of)

$

104,543

2019

159,242

2020

164,903

2021

182,512

2022

190,141

2023 and thereafter

573,883

Total

$

1,375,224

16

Rental expenses charged to operations for
the three and six months ended June 30, 2018 and 2017 was $170,949 and $114,167, and $87,067 and $80,147 respectively.

Litigation

The Company is subject to legal proceedings
and claims which arise in the ordinary course of its business. Although occasional adverse decisions or settlements may occur,
the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position,
results of operations or liquidity.

Sales Tax

The following table sets forth the change in the sales tax accrual
as of June 30, 2018 and December 31, 2017:

June 30, 2018

December 31, 2017

Balance, beginning of year

$

83,282

$

274,869

Sales tax collected

41,817

297,673

Provisions

23,181

(33,000

)

Interest and penalties

–

(5,890

)

Payments

(105,950

)

(450,370

)

Balance, end of period

$

42,330

$

83,282

NOTE L – BUSINESS CONCENTRATION

For the six months ended June 30, 2018,
one customer represented approximately 11% of total net revenues. For the six months ended June 30, 2017, no single customer represented
10% or more of total net revenues. As of June 30, 2018, four customers accounted for approximately 54% of the Company’s net
accounts receivable. As of December 31, 2017, three customers accounted for approximately 54% of the Company’s net accounts
receivable.

Purchases from one supplier approximated
$1,975,000, or 88%, of purchases for the six months ended June 30, 2018 and $1,439,000, or 84%, of purchases for the six months
ended June 30, 2017. Total due to this supplier, net of deposits, was approximately $490,000, as of June 30, 2018, and $33,000
as of December 31, 2017.

NOTE M – DISCONTINUED OPERATIONS

During the year ended December 31,
2017, the Company, and EthoStream, entered into an Asset Purchase Agreement (the “Purchase Agreement”) with
DCI-Design Communications LLC (“DCI”), a Delaware limited liability company, whereby DCI acquired substantially
all of the assets and certain liabilities of EthoStream for a base purchase price of $12,750,000. The Purchase Agreement
provided that $900,000 of the $12,750,000 base purchase price was placed into an escrow account to support potential
indemnification obligations of up to $800,000 and net working capital adjustments of up to $100,000. On April 06, 2018, the
Company received the $800,000 disbursement from the funds held in escrow. The Company reclassified the balance from
restricted cash to cash at March 31, 2018.

On March 29, 2017, pursuant to the terms
and the conditions of the Purchase Agreement, the Company closed on the sale.

As of June 30, 2018 and December 31, 2017
there were no assets or liabilities of discontinued operations.

17

The following table summarizes the statements
of operations information for discontinued operations.

Three Months Ended

June 30,

Six Months Ended

June 30,

2018

2017

2018

2017

Revenues, net:

Product

$

–

$

–

$

–

$

653,839

Recurring

–

–

–

925,837

Total Net Revenue

–

–

–

1,579,676

Cost of Sales:

Product

–

(10,225

)

–

414,604

Recurring

–

689

–

209,868

Total Cost of Sales

–

(9,536

)

–

624,472

Gross Profit

–

9,536

–

955,204

Operating Expenses:

Selling, general and administrative

–

(9,924

)

–

252,110

Depreciation and amortization

–

–

–

60,420

Total Operating Expenses

–

(9,924

)

–

312,530

Income from Discontinued Operations before Provision for Income Taxes

–

19,460

–

642,674

Provision for Income Taxes

–

605

–

52,017

Income from Discontinued Operations (net of tax)

$

–

$

18,855

$

–

$

590,657

The consolidated statements of cash flows
do not present the cash flows from discontinued operations for investing activities or financing activities because there were
no investing or financing activities associated with the discontinued operations in the periods ended June 30, 2018 and 2017.

18

Item 2. Management’s Discussion and Analysis of
Financial Condition and Results of Operations

The following discussion and analysis of
the Company’s financial condition and results of operations should be read in conjunction with the accompanying condensed
consolidated financial statements and related notes thereto for the three and six months ended June 30, 2018, as well as the Company’s
consolidated financial statements and related notes thereto and management’s discussion and analysis of financial condition
and results of operations in the Company’s Form 10-K for the year ended December 31, 2017, filed with the US Securities and
Exchange Commission (the “SEC”) on April 2, 2018.

Business

Telkonet, Inc. (the “Company”,
“Telkonet”), formed in 1999 and incorporated under the laws of the state of Utah, is the creator of the EcoSmart Platform
of intelligent automation solutions designed to optimize energy efficiency, comfort and analytics in support of the emerging Internet
of Things (“IoT”).

In October of 2016, the Company, under
the direction and authority of the Board of Directors, committed to a plan to offer for sale EthoStream LLC (“EthoStream”),
its wholly-owned High-Speed Internet Access (“HSIA”) subsidiary. While EthoStream was one of the largest public
HSIA providers in the world, providing services to more than 12.0 million users monthly across a network of approximately 1,800
locations, the Company focused on its higher growth potential EcoSmart Platform line. As a result of this decision to sell EthoStream,
the operating results of EthoStream for the three and six months ended June 30, 2017 have been reclassified as discontinued operations
in the condensed consolidated statement of operations and as assets and liabilities of discontinued operations. The sale closed
on March 29, 2017.

The Company’s direct sales effort
targets the hospitality, education, commercial, utility and government/military markets. Taking advantage of legislation, including
the Energy Independence and Security Act of 2007, or EISA, the Energy Policy Act of 2005, and the American Recovery and Reinvestment
Act the Company is focusing its sales efforts in areas with available public funding and incentives, such as rebate programs offered
by utilities for efficiency upgrades. Through the Company’s proprietary platform, technology and partnerships with energy
efficiency providers, the Company’s management intends to position the Company as a leading provider of energy management
solutions.

Forward-Looking Statements

In accordance with the Private Securities
Litigation Reform Act of 1995, the Company can obtain a “safe-harbor” for forward-looking statements by identifying
those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual
results to differ materially from those in the forward-looking statements. Accordingly, the following “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” may contain certain forward-looking statements
regarding strategic growth initiatives, growth opportunities and management’s expectations regarding orders and financial
results for the remainder of 2018 and future periods. These forward-looking statements are based on current expectations and current
assumptions which management believes are reasonable. However, these statements involve risks and uncertainties that could cause
actual results to differ materially from any future results encompassed within the forward-looking statements. Factors
that could cause or contribute to such differences include those risks affecting the Company’s business as described in the
Company’s filings with the SEC, including the current reports on Form 8-K, which factors are incorporated herein by reference.
The Company expressly disclaims a duty to provide updates to forward-looking statements, whether as a result of new information,
future events or other occurrences.

Critical Accounting Policies and
Estimates and New Accounting Pronouncements

Please refer to the Company’s form
10K filed April 2, 2018 for critical accounting policies and estimates. For information regarding recent accounting pronouncements
and their effect on the Company, see “New Accounting Pronouncements” in Note B of the Notes to Unaudited Condensed
Consolidated Financial Statements contained herein.

Product revenue principally arises from
the sale and installation of the EcoSmart energy management platform. The EcoSmart Suite of products consists of thermostats, sensors,
controllers, wireless networking products switches, outlets and a control platform.

For the three and six months ended June
30, 2018, product revenue increased by 40% or $0.8 million and 13% or $0.5 million, respectively, when compared to the prior year.
For the three months ended June 30, 2018, sales of actual product increased by $0.13 million and installation revenue increased
by $0.64 million. The hospitality market comprised $2.06 million of product sales for the three months ended June 30, 2018, a
$0.56 million increase from the prior year period. The education market sales for the three months ended June 30, 2018 increased
$0.42 million to $0.65 million from $0.23 million for the prior year period. The Multiple Dwelling Unit (“MDU”) market
decreased $0.15 million from $0.20 million for the three months ended June 30, 2017 to $0.05 million for the three months ended
June 30, 2018. The hospitality market sales for the six months ended June 30, 2018 increased $0.63 million to $3.53 million from
$2.9 million for the prior year period. The education market sales for the six months ended June 30, 2018 decreased $0.05 million
to $0.65 million from $0.7 million for the prior year period and the MDU market sales for the six months ended June 30, 2018 decreased
$0.23 million to $0.07 million from $0.3 million for the prior year period. The Company’s commitment to access distribution
channels through resellers and value added distribution partners remained stable. Product revenue derived from channel partners
increased $1.3 million for the six months ended June 30, 2018 compared to the prior year period.

Recurring Revenue

Recurring revenue is attributed to our
call center support services. The Company recognizes revenue ratably over the service month for monthly support revenues and defers
revenue for annual support services over the term of the service period. Recurring revenue consists of Telkonet’s EcoCare
service and support program.

For the three and six months ended June
30, 2018, recurring revenue increased by 39% and 20%, respectively, when compared to the prior year period.

20

Cost of Sales

Three Months Ended

June 30, 2018

June 30, 2017

Variance

Product

$

1,376,729

49%

$

1,065,914

53%

$

310,815

29%

Recurring

66,482

43%

32,627

30%

33,855

104%

Total

$

1,443,211

49%

$

1,098,541

52%

$

344,670

31%

Six Months Ended

June 30, 2018

June 30, 2017

Variance

Product

$

2,370,966

55%

$

2,073,959

54%

$

297,007

14%

Recurring

126,479

50%

62,645

29%

63,834

102%

Total

$

2,497,445

55%

$

2,136,604

53%

$

360,841

17%

Costs of Product Sales

Costs of product revenue include equipment
and installation labor related to EcoSmart technology. For the three and six months ended June 30, 2018, product costs increased
by 29% and 14%, respectively, compared to the prior year periods. For the three month comparison, the materials costs as a percentage
of product sales increased by 37% compared to the comparable period. The cost of materials increased $0.29 million and inventory
adjustments decreased $0.09 million. The Company’s use of outside contractors for installations increased resulting in a
$0.11 million increase in contractor services costs. For the six month comparison, material costs increased $0.21 million, use
of outside contractors for installations increased resulting in a $0.03 million increase in contractor services. These increases
were partially offset by a $0.17 million adjustment in inventory costs.

Costs of Recurring Revenue

Recurring costs are comprised of labor
and telecommunication services for our customer service department. For the three and six months ended June 30, 2018, recurring
costs increased by 104% and 102%, respectively, when compared to the prior year periods. These variances were primarily due to
salary, benefits and temporary staffing.

Gross Profit

Three Months Ended

June 30, 2018

June 30, 2017

Variance

Product

$

1,444,076

51%

$

948,008

47%

$

496,068

52%

Recurring

86,875

57%

77,574

70%

9,301

12%

Total

$

1,530,951

51%

$

1,025,582

48%

$

505,369

49%

Six Months Ended

June 30, 2018

June 30, 2017

Variance

Product

$

1,953,497

45%

$

1,750,348

46%

$

203,149

12%

Recurring

128,416

50%

150,398

71%

(21,982

)

(15%

)

Total

$

2,081,913

45%

$

1,900,746

47%

$

181,167

10%

21

Gross Profit on Product Revenue

Gross profit for the three and six months
ended June 30, 2018 increased by 52% and 12%, respectively, when compared to the prior year periods. The actual gross profit percentage
increased from 47% for the three months ended June 30, 2017 to 51% for the three months ended June 30, 2018. For the six months
ended June 30, 2018 and 2017, the gross profit percentage decreased 1% from 46% at June 30, 2017 to 45% at June 30, 2018. The
decrease was directly related to cost of goods sold and outside services.

Gross Profit on Recurring Revenue

The gross profit associated with recurring
revenue increased by 12% and decreased by 15%, respectively, for the three and six months ended June 30, 2018 when compared to
the prior year periods. For the three months ended June 30, 2018, the actual gross profit percentage decreased 13% compared
to the prior year period, from 70% to 57%. For the six months ended June 30, 2018, the actual gross profit percentage decreased
21% compared to the prior year period, from 71% to 50%.

Operating Expenses

Three Months Ended June 30,

2018

2017

Variance

Total

$

1,739,587

$

1,892,506

$

(152,919

)

(8%)

Six Months Ended June 30,

2018

2017

Variance

Total

$

3,472,185

$

4,050,564

$

(578,379

)

(14%)

During the three and six months ended June
30, 2018, operating expenses decreased by 8% and 14%, respectively, when compared to the prior year periods as outlined below.

Research and Development

Three Months Ended June 30,

2018

2017

Variance

Total

$

431,856

$

444,557

$

(12,701

)

(3%)

Six Months Ended June 30,

2018

2017

Variance

Total

$

870,636

$

823,013

$

47,623

6%

Research and development costs are related
to both present and future products and are expensed in the period incurred. Current research and development costs are associated
with product development and integration. During the three and six months ended June 30, 2018, research and development costs decreased
by 3% and increased by 6%, respectively, when compared to the prior year periods. For the three month comparison, the variance
is due to an approximate $0.02 million decrease in salaries along with an approximate $0.03 decrease in certification expenses,
all partially offset by an increase of $0.05 million for consulting expenses. For the six month comparison the variance is due
to a $0.12 million increase in consulting expenses, partially offset by a $0.05 decrease in certification expenses.

22

Selling, General and Administrative Expenses

Three Months Ended June 30,

2018

2017

Variance

Total

$

1,291,103

$

1,483,069

$

(191,966

)

(13%)

Six Months Ended June 30,

2018

2017

Variance

Total

$

2,568,006

$

3,207,762

$

(639,756

)

(20%)

During the three and six months ended June
30, 2018, selling, general and administrative expenses decreased over the prior year periods by 13% and 20%, respectively. For
the three month comparison, due to the sale of EthoStream, the Company was able to decrease executive, accounting and sales salaries,
wages and benefits of $0.05 million. An $0.08 million decrease was a result of the Company’s decision to not retain a marketing
consulting firm. An $0.05 million decrease was the results of a decrease in bad debt expense.

For the six month comparison, due to the
sale of EthoStream, the Company was able to decrease executive, accounting and sales salaries, wages and benefits of $0.16 million.
A $0.09 million decrease was a result of the Company’s decision to not retain a marketing consulting firm. A $0.07 million
decrease was the results of a decrease in bad debt expense. Additionally, a $0.32 million decrease was the results of a decrease
in stock option expense.

Income from Discontinued Operations, Net of Tax

Three Months Ended June 30,

2018

2017

Variance

Total

$

–

$

18,885

$

(18,885

)

(100%)

Six Months Ended June 30,

2018

2017

Variance

Total

$

–

$

590,657

$

(590,657

)

(100%)

Income from discontinued operations decreased
$0.02 million or 100% and $0.59 million or 100% for the three and six months ended June 30, 2018 over the prior year periods. For
the three and six months ended June 30, 2018 there was no activity from discontinued operations.

23

EBITDA from Continuing Operations

Management believes that certain non-GAAP
financial measures may be useful to investors in certain instances to provide additional meaningful comparisons between current
results and results in prior operating periods. Adjusted earnings before interest, taxes, depreciation and amortization (“Adjusted
EBITDA”) is a metric used by management and frequently used by the financial community. Adjusted EBITDA provides insight
into an organization’s operating trends and facilitates comparisons between peer companies, since interest, taxes, depreciation
and amortization can differ greatly between organizations as a result of differing capital structures and tax strategies. Adjusted
EBITDA is one of the measures used for determining our debt covenant compliance. Adjusted EBITDA excludes certain items that are
unusual in nature or not comparable from period to period. While management believes that non-GAAP measurements are useful supplemental
information, such adjusted results are not intended to replace our GAAP financial results. Adjusted EBITDA is not, and should not
be considered, an alternative to net income (loss), income (loss) from operations, or any other measure for determining operating
performance of liquidity, as determined under accounting principles generally accepted in the United States (GAAP). In assessing
the overall health of its business for the three and six months ended June 30, 2018 and 2017, the Company excluded items in the
following general category described below:

·

Stock-based compensation: The Company believes that because of the variety of equity awards used by companies, varying methodologies for determining stock-based compensation and the assumptions and estimates involved in those determinations, the exclusion of non-cash stock-based compensation enhances the ability of management and investors to understand the impact of non-cash stock-based compensation on our operating results. Further, the Company believes that excluding stock-based compensation expense allows for a more transparent comparison of its financial results to the previous period.

·

Bonus paid to executives upon sale of discontinued operations: The Company does not consider the bonuses of $87,750 associated with the sale of EthoStream to be indicative of current or future operating performance. Therefore, the Company does not consider the inclusion of these costs helpful in assessing its current financial performance compared to the previous year.

RECONCILIATION OF NET LOSS FROM

CONTINUING OPERATIONS TO ADJUSTED EBITDA

(Unaudited)

Three Months Ended

June 30,

Six Months Ended

June 30,

2018

2017

2018

2017

Net loss from continuing operations

$

(206,582

)

$

(869,406

)

$

(1,390,748

)

$

(2,163,644

)

Interest (income) expense, net

(4,054

)

(4,428

)

(1,524

)

5,925

Provision for income taxes

2,000

6,910

2,000

7,901

Depreciation and amortization

16,628

9,880

33,543

19,789

EBITDA – continuing operations

(192,008

)

(857,044

)

(1,356,729

)

(2,130,029

)

Adjustments:

Stock-based compensation

1,531

3,516

3,061

318,202

Bonus paid to executives upon sale of discontinued operations

–

–

–

87,750

Adjusted EBITDA

$

(190,478

)

$

(853,528

)

$

(1,353,668

)

$

(1,724,077

)

24

Liquidity and Capital Resources

The Company has financed its operations
since inception primarily through private and public offerings of the Company’s equity securities, the issuance of various
debt instruments and asset based lending, and the sale of assets.

Working Capital

Working capital (current assets in excess
of current liabilities) from continuing operations decreased by $1,756,774
during the six months ended June 30, 2018 from a working capital of $9,480,565 at December 31, 2017 to working capital of $7,723,791
at June 30, 2018.

Revolving Credit Facility

The Heritage Bank Loan Agreement contains
representations and warranties, covenants, and other provisions customary to transactions of this nature. As of June 30, 2018,
the Company was in compliance with all financial covenants. The outstanding principal balance of the Credit Facility bears interest
at the Prime Rate plus 3.00%, which was 8% at June 30, 2018 and 7.50% at December 31, 2017. The outstanding balance on the Credit
Facility was zero and $682,211 at June 30, 2018 and December 31, 2017, respectively. The remaining available borrowing capacity
was approximately $1,622,000 and $202,000 at June 30, 2018 and December 31, 2017, respectively.

On March 31, 2018, an amendment to the
revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the
terms of the amendment was that if the Company fails to comply with required EBITDA covenants as of any particular quarterly measurement
date, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted cash maintained
at Heritage Bank is in excess of $5,000,000.

Cash Flow Analysis

Cash used in continuing operations
was $2,179,004 and $1,770,068 during the six months ended June 30, 2018 and 2017, respectively. As of June 30, 2018, our
primary capital needs included costs incurred to increase energy management sales, inventory procurement, and managing
current liabilities. The working capital changes during the six months ended June 30, 2018 were primarily related to an
approximate $373,000 increase in accounts receivable, a $453,000 increase in prepaid expense and other current assets, offset
by a $277,000 decrease in inventory, a $124,000 decrease in customer deposits, a $512,000 decrease in deferred
revenues and an $18,000 decrease in accounts payable. The working capital changes during the six months ended June 30, 2017
were primarily related to an approximate $140,000 increase in accounts receivable, offset by a $75,000 decrease in
inventory, a $160,000 increase in customer deposits, a $76,000 decrease in accrued liabilities and expenses and a
$97,000 decrease in accounts payable. Accounts receivable fluctuates based on the negotiated billing terms with customers and
collections. We purchase inventory based on forecasts and orders, and when those forecasts and orders change, the amount of
inventory may also fluctuate. Accounts payable fluctuates with changes in inventory levels, volume of inventory purchases,
and negotiated supplier and vendor terms.

Cash used in investing activities was $7,493
during the six months ended June 30, 2018. Cash provided by investing activities was $11,793,209 during the six months ended June
30, 2017. During the six months ended June 30, 2018, the cash used by investing activities reflects a decrease of $7,493 associated
with the purchase of property and equipment. During the six months ended June 30, 2017, the cash provided reflects the proceeds
less adjustments associated with the sale of the assets and certain liabilities assumed of the Company’s wholly-owned subsidiary,
EthoStream and a decrease of $12,011 associated with the purchase of computer equipment.

25

Cash used in financing activities was $682,211
and $1,062,129 during the six months ended June 30, 2018 and 2017, respectively. Cash used for payments on the line of credit were
$682,211 during the six months ended June 30, 2018. The Heritage Bank Loan Agreement for the Company’s line of credit included
the Company and EthoStream as co borrowers. Upon closing the EthoStream sale transaction
on March 29, 2017, the entire balance outstanding on the Credit Facility, $1,062,129, was repaid.

We are working to manage our current liabilities
while we continue to make changes in operations to improve our cash flow and liquidity position.

Management expects that global economic
conditions, in particular the decreasing price of energy, along with competition will continue to present a challenging operating
environment through 2018; therefore working capital management will continue to be a high priority for 2018. The Company’s
estimated cash requirements for our operations for the next 12 months is not anticipated to differ significantly from our present
cash requirements for our operations.

Off-Balance Sheet Arrangements

The Company has no material off-balance
sheet arrangements.

Acquisition or Disposition of Property
and Equipment

The Company does not anticipate significant
purchases of property or equipment during the next twelve months. The Waukesha, Wisconsin lease may require additional furniture,
shelving, computer equipment and peripherals to be used in the Company’s day-to-day operations.

Item 4. Controls and Procedures.

As of June 30, 2018, the Company performed
an evaluation, under the supervision and with the participation of management, including the Chief Executive Officer and the Chief
Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Management has identified
control deficiencies regarding the lack of segregation of duties due to the limited size of the Company’s accounting department,
a failure to implement adequate internal control over financial reporting including in our IT general control environment, and
the need for a stronger internal control environment particularly in our financial reporting and close process. We lack sufficient
personnel resources and technical accounting and reporting expertise to appropriately address certain accounting and financial
reporting matters in accordance with generally accepted accounting principles. We did not have an adequate process or appropriate
controls in place to support the accurate reporting of our financial results and disclosures on our Form 10-Q. Management of the
Company believes that these material weaknesses are due to the small size of the Company’s accounting staff. The small size
of the Company’s accounting staff may prevent adequate controls in the future, such as segregation of duties, due to the
cost/benefit of such remediation. The Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls
and procedures were ineffective as of the end of the period covered by this report.

We are reviewing actions to remediate the
identified material weaknesses. As we continue to evaluate and work to improve our internal controls over financial reporting,
our senior management may determine to take additional measures to address deficiencies or modify the remediation efforts. Until
the remediation efforts that our senior management identifies as necessary, are completed, tested and determined effective, the
material weaknesses described above will continue to exist.

In light of these material weaknesses,
we performed additional analyses and procedures in order to conclude that our condensed consolidated financial statements as of
June 30, 2018 and 2017 included in this Form 10-Q were fairly stated in accordance with GAAP. Accordingly, management believes
that despite our material weaknesses, our condensed consolidated financial statements for the three and six months ended June 30,
2018 and 2017 are fairly stated, in all material respects, in accordance with GAAP.

26

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

The Company is subject to legal proceedings
and claims which arise in the ordinary course of its business. Although occasional adverse decisions or settlements
may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial
position, results of operations or liquidity.

Item 1A. Risk Factors.

Investors should consider carefully the
following risk factors in addition to the other information included and incorporated by reference in this Quarterly Report on
Form 10-Q that we believe are applicable to our business and the industries in which we operate.

New tariffs and evolving trade policy
between the United States and China may have a material adverse effect on our business.

During 2018, the United States Federal
Government imposed significant tariffs on imports from numerous countries, including China. Subsequent to this, the Office of the
United States Trade Representative (“USTR”) announced an initial proposed list of imports from China that could be
subject to additional tariffs. The list of imports for which Customs and Border Protection began collecting additional duties during
July 2018, focuses on the industrial sector. The Company’s main supplier, accounting for over 80% of total purchases, is
located in China. The products that the Company purchases from the supplier are subject to up to 25% tariffs. As a result, the
tariffs will directly increase our cost of sales.

In addition, these new tariffs and the
evolving trade policy dispute between the United States and China may have a significant impact on the industries in which we
participate. Further governmental action related to tariffs or international trade agreements or policies has the potential to
adversely impact demand for our products, our costs, customers, suppliers and/or the United States economy, thus, to adversely
impact our businesses and results of operations.